Month: September 2009

End users of derivatives including chemical companies and airlines are worried about how high the proposed “capital charges” on those over the counter derivatives that are not cleared will be set. It is true that such charges are likely to increase costs for firms that wish to hedge risk on over the counter markets.

I’d like to propose an alternative means of stabilizing over the counter derivative markets that aren’t suitable for clearing: Prohibit the posting of collateral on over the counter derivative contracts. In the event that a firm trading these OTC derivatives declares bankruptcy, the derivative counterparties would have to stand in line with all the creditors of the firm to get payment.

The idea behind this reform is that the best way to stabilize over the counter derivative markets is to ensure that the only firms that are acceptable as counterparties are firms with strong balance sheets.

Since overindebted firms would in all likelihood be shut out of these markets, a transitional period would probably be necessary. Thus, a two track uncleared OTC market could be allowed to operate for 5 to 10 years. One class of derivatives would involve neither collateral posting nor capital charges and the other class would have capital charges that increased steadily over time until the market in “old-fashioned” destabilizing derivatives was finally shut down.

I am a firm supporter of regulation where it is successful. But I’m also a firm believer in thinking hard about what it means for regulation to be successful. Perhaps money market funds are an example of an investment product that was made dangerous by “successful” regulation.

Money market funds are built on a contradiction. They are investment funds — and like any investment fund expose investors to losses; however, they are allowed to report and calculate their returns as if the Net Asset Value of one share in the fund is always equal to $1. This subterfuge means that under normal circumstances a well managed money market fund will behave a lot like a bank savings account: any money an investor puts in the account stays there until it is withdrawn and periodically the account accrues interest.

In the absence of regulation this subterfuge would be recognized for what it is — because there would always be a bunch of high-flying money funds malinvesting assets and going bust. Every investor would know to take the warning about possible losses seriously and would spend time evaluating the quality of money market funds.

Over the past couple of decades, however, money market funds have been carefully regulated and in the 25 years preceding the Reserve Fund failure there was only one small money fund failure. This successful regulation bred complacency amongst investors who began to to view money market funds as excellent substitutes for bank deposits.

In my view the fact that investment funds were treated as having NAVs of $1 was misleading in an environment where these bank-like investment funds almost never failed. Investors were told that money funds (i) were investment accounts that could lose value and (ii) would almost certainly preserve a NAV of $1 per share. For obvious reasons both statements can not be true simultaneously.

Each shareholder in an investment fund has a right to his or her share of the underlying assets — neither more, nor less. The use of a fixed NAV for money funds makes it appear that shareholders have a right to more than the simple fraction of assets that they own.

Despite the fact that money funds advertise a NAV of $1 per share, their only assets are the assets of the investment fund. Thus, money funds have no way to support the NAV that they advertise. This is a problem.

In my view, any fund that seeks to maintain a fixed NAV per share must necessarily establish a reserve fund that will be used to support the fixed NAV in the event that value of the investment fund in fact falls. Any fund that claims to maintain a fixed NAV without maintaining a reserve fund is guilty of false advertising.

In short, because money funds are inherently contradictory financial products, regulators made a mistake by permitting their development. And compounded this mistake by regulating the product so strictly that failures were effectively eliminated. The lesson I take from this: Either regulators need to be very critical of financial innovation and repress products that are based on contradictory premises, or regulators need to remember that markets are often strengthened, not weakened by failures and allow unsafe versions of such products to be sold to investors.

The worst outcome for regulators is the current money market fund situation: the product is inherently contradictory, but it is so heavily regulated that the market’s faults have become the responsibility of regulators. We must not forget that there are tensions between protecting investors from bad products, promoting efficient financial innovation and allowing failure to act as a market force that limits systemic risk.

Johnson and Kwak claim: “The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made–because they destroyed value.” They described the process of tricking investors as “the magic of a CDO”.

And Economic of Contempt responds: “This is usually how CDOs are portrayed these days: they’re obviously voodoo finance … But as you can see, the idea that the senior tranche would be “safe” isn’t at all ridiculous—after all, there’s almost always some level of subordination that will make the senior tranche a safe investment.”

Of course, this is not actually a response to the claim that “some” CDOs destroyed value. EoC doesn’t claim that for every single CDO there is a level of subordination that will make the senior most tranche a AAA investment, because EoC knows very well that for certain classes of CDOs (e.g. mezzanine ABS CDOs) there is no level of subordination that will turn the senior most tranche into a AAA investmnet.

Furthermore even when one deals with those CDOs for which it is true that there exists some level of subordination that makes the senior most tranche AAA, as EoC himself notes, the problem is that each CDO defined a specific level of subordination at which the investment became AAA. In recent years this level was usually set at a ridiculously low level.

Finally investment banks claimed to be able to price these CDOs accurately enough to sell them as investments to their clients. Of course, the truth was that very few investment banks (i) made appropriate allowances for the likelihood that mortgage defaults would be highly correlated when the housing bust finally arrived — which would have resulted in higher fair market yields for every tranche and rendered many CDOs non-viable economically as recognized by the folks at JP Morgan (who apparently concluded that “the idea that the senior tranche would be ‘safe’ ” is ridiculous when you’re talking about mortgage based CDOs); and (ii) apparently didn’t do the loan level research necessary to accurately price CDOs — or they would have found lots of fraud in recent vintage CDOs that included subprime RMBS.

So in answer to the question: Are the CDO issuance practices of 2005 – 2007 accurately described as voodoo finance? The answer is yes. Because some fortune teller in an investment bank was claiming (with advice from the rating agencies) to be able to (i) determine subordination levels for AAA and other tranches with extraordinary accuracy; (ii) to be able to predict future correlations, even though two-bit investor is warned that “past performance may not be a good indicator of future performance” and you’d think the investment bankers had been around long enough to learn that simple rule and (iii) to be able to accurately price a composite asset without doing extensive research on the underlying individual assets.

What’s ridiculous is the claim that people like Johnson and Kwak are giving CDOs a bad name. The investment banks were able to do that all by themselves.